Net Investment Income Has a Tax Bite

Did your investments see a big jump in value over the year 2013? Did your mutual fund dump a chunk of capital gains into your tax picture? Even if you leave the capital gains in your investment account you will be taxed on it.

While you may be surprised by this additional income, capital gains and qualified dividends or dividends from stocks – do receive a reduced tax rate. That tax rate depends on your Modified Adjusted Gross Income – MAGI.


-To minimize your Capital Gains exposures consider using Mutual Funds that keep their portfolio turnover low. Portfolio turnover causes the capital gains/losses in your investment.

– Use Index Mutual Funds. These funds mirror a given index like S&P 500 Index. Because there is little change in the stocks included in an index, these funds see less change.

-ETF or Exchange Traded Funds can also help minimize your Capital Gain exposure. While an ETF will have a pool of stocks, like a Mutual Fund, they are structured differently. ETF’s can exchange a stock for another stock using a fund custodian. This functions much like a 1031 Exchange on real estate.

-The capital gains rates are:

  Long Term

Capital Gains

Return                    Single                     Married, Filing Joint


20%             $406,751 – Above              $457,601 – Above

15%              $  36,901 – $406,750       $  73,801 – $457,600

0%              $           0 – $  36,900       $          0 – $  73,800


While ETF’s won’t exclude all Capital Gains from the portfolio, it may reduce the exposure. And just as with a Mutual Fund, if you sell shares, you may have a Capital Gain/Loss.

Another surprise tax or stealth tax you may have experienced in filing your 2013 tax return is the Investment Surtax of 3.8%. You may have heard of this as the Medicare Tax on Investments. The rate is similar to the 2.9% Medicare Tax plus the additional.9% tax for a total of 3.8%. However, none of the tax collected from this source is designated for Medicare expenses.

This surtax has a MAGI threshold to which the tax applies. Any Net Investment Income that is over your tax filing threshold will have an additional tax of 3.8%.

Married, Filing Joint     $250,000

Single                             $200,000

Married, Filing Single   $125,000

Trusts and Estates       $ 12,000

Net investment income includes taxable interest, ordinary dividends, and annuity income from non-qualified plans, royalties, capital gains, rentals and other passive income.

For example: If Sam, a single taxpayer, has Net Investment Income (NII) of $90,000 and wages of $180,000 (MAGI equals $270,000) Sam is subject to the NII Tax on $70,000, the amount by which his MAGI exceeds $200,000 threshold amount. The full $90,000 of NII tax is not taxed, only the excess over $200,000 or $70,000. Sam’s NII tax is $2,660 ($70,000 X 3.8%).

The threshold for being subject to the NII tax is NOT indexed for inflation. So while it may not be an issue for you today, it could become an issue in later years. Similar to the Alternative Minimum Tax was not indexed. AMT was designed for high income earners to pay more taxes, but over time middle income tax payers are finding their tax bill increased from this amount.

Tips: Sheltering taxable income becomes important in reducing your MAGI. Deferred annuities shelter your gains from taxes until withdrawals are made. Non-qualified annuities add to NII when they pay out, hopefully when you have a lower taxable income.

Annuities generally defer taking income until retirement. Non-qualified annuity distributions are usually not required until age 90; although this can vary by contract. However, you can be strategic in when and how much you access the non-qualified annuity. Qualified annuity contracts may involve Required Minimum Distributions or RMDs.

Roth IRA’s are another strategy to shelter taxable income. Unfortunately, if your income is subject to the NII, you aren’t going to be eligible for new contributions. You may have an option to use a Roth in your employer’s 401(k) that doesn’t have income restrictions for contributing.

You may also want to evaluate what your income may be in retirement years. Does it make sense to do a Roth conversion today to reduce income in later years?

This isn’t intended to be a comprehensive review of the current tax law.

You should consult your tax professional.

Securities and advisory services through KMS Financial Services, Inc.





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